Chapter 6: Chinese Bond Market and Interbank Market 1

Transcription

1 Handbook on Chinese Financial System Chapter 6: Chinese Bond Market and Interbank Market 1 Marlene Amstad and Zhiguo He Target: min 15, max 40 pages. Approx 1500 charac. per page : min max Current number of pages: 48. Current number of characters: Contents 1 Overview of Chinese Bond Markets Bond Markets and Bond Types Segmented Bond Markets The Interbank Market The Exchange Market Bond Types Government Bonds Financial Bonds Corporate Bonds Summary A Brief History of Chinese Bond Markets Physical Bond Counter Market The Exchange Market Era The Rise of Interbank Market Bond Markets and the Growth of Chinese Economy Issues and Recent Trends of Chinese Bond Markets Interest Rate Determination and Monetary Policy Transmission The Role of Banks and Shadow Banking Regulatory Tightening Starting Internalization of Chinese Bond Market Bond Ratings and Rating Agencies China s Credit Rating Scale Distribution of Credit Ratings Low Default Rate, Implicit Guarantees and Rating Migration Regulatory Framework Rating Agencies Outlook Credit Spreads and Default in Chinese Bond Market Bond Defaults in China: A Summary Defaults, Bond Ratings, and Credit Spreads Bond Default Cases, Bankruptcy, and Post-default Recovery Amstad: The Chinese University of Hong Kong, Shenzhen, marleneamstad@cuhk.edu.cn. Zhiguo He: University of Chicago, Booth School of Business, and NBER; Tsinghua University, School of Economics and Management. zhiguo.he@chicagobooth.edu, website: We thank Tianshu Lyu for excellent research assistance in preparing this chapter, and Zhuo Chen (PBC School of Finance at Tsinghua University) and Rengming Xie (CITIC Securities, China) for many useful comments and discussions.

2 7 Data Sources on Chinese Bond Markets Data from Wind China Foreign Exchange Trading System PBoC Statistic Reports Issues in Using the Interbank Market Data Overview of Chinese Bond Markets Over the past twenty years, especially the past decade, China has taken enormous strides to develop its bond market as an integral step of financial reform, along with its tremendous effort in interest rate liberalization and internalization of its currency RMB. Figure 1 Panel A depicts the growth of Chinese bond market capitalization scaled by GDP in the past decade; we observe that bond market capitalization over GDP rises from 35% in 2008 to more than 90% in For comparison, the bond market capitalization over GDP in US stays slightly above 200% during the same time period. Relative to the stock market capitalization, Chinese bond market has been also experiencing a steady uprising trend, only to catch up to the US level which is about 130% in Due to historical reasons, there are two distinct and largely segmented markets in today s Chinese bond markets: Over-the-Counter based interbank market, and centralized exchange market. The interbank bond market in China resembles the interbank market observed in developed countries like US, while the exchange bond market in China is part of the Stock Exchanges in Shanghai and Shenzhen. Section 4.1 offers a brief history of the development and evolution of these two bond markets. The interbank market is the dominant one within these two markets; at the end of 2017, about 89% of the total bonds outstanding in China are in the interbank market, while the rest of 11% is in the exchange. 2 Various fixed income securities are issued and traded on these two bond markets, with many multi-layer regulatory bodies interacting with each other in an intricate way. We first elaborate on the above mentioned two bond markets in Section 2, together with various bond instruments traded there. Section 3 provides a brief history of Chinese bond markets, and Section 4 highlights their inherent connection with and the banking system, together the internalization of Chinese bond markets in the near future. Section 5 covers the credit ratings and rating agencies, and Section 6 offers an account of ever-rising default incidents in China starting We provide some data sources for in-depth study of Chinese bond market in Section 7. 2 Besides these two major bond markets, there is also a Counter Trading System through which retail investors trade bonds with commercial banks at their bank counters. This retail Over-the-Counter market can be considered as the natural extension of the whole interbank market.

3 2 Bond Markets and Bond Types In this section we first go over the details of the two segmented Chinese bond markets, i.e., the interbank market and the exchange market. After explaining the various bond security types traded in Chinese bond markets, we provide a comparison between these two bond markets. 2.1 Segmented Bond Markets The Interbank Market ( 银行间市场 ) The interbank bond market, often called as the China Interbank Market (CIBM, 中国银行间债券市场 ), was established in 1997 and has become the dominating market for bond issuance and trading in China. Beside spot and repurchase transactions, swaps and futures are also actively trade by participants in the interbank market. The value of outstanding bonds in the interbank market reached 66 trillion RMB at the end of 2017, with an annual issuance of 39 trillion RMB in the same year. As a wholesale market, the participants of interbank market are restricted to various qualified institutional investors including commercial banks, mutual funds, insurance companies, and security firms. As shown in Figure 2, commercial banks (e.g., state-owned commercial banks, join-stock commercial banks, urban and rural credit unions, etc.) form the largest group of institutional investors who held about 58% of the outstanding bonds in the interbank market in The second largest group is mutual funds, broadly defined to include the fast-growing asset management industry thanks to the rise of wealth-management products after 2012; they held about 28% of outstanding bonds in the interbank market. Security firms, insurance companies, and foreign institutions are the next; these three groups of institutional investors formed a market share of 6.58% in the interbank market. The main regulator of the interbank market is the People s Bank of China (PBoC, 中国人民银行 ), the central bank in China. Participants in the interbank market trade via China Foreign Exchange Trade System (CFETS, 外汇交易中心 ), and all participating institutions are required to open their accounts in China Central Depository & Clearing Co. Ltd (CCDC, 中债登 ), a leading depository and clearing house in China. After the terms of trades are finalized through bilateral bargaining, CFETS record these transactions and CCDC offers exclusive custodial and clearing services in the interbank market. This monopolistic position came to an end after the establishment of Shanghai Clearing House (SHCH, 上清所 ) on November Led by the PBoC, SHCH competes with CCDC by offering clearing services for products like Medium-term Notes, Commercial Papers, and Private Placement Notes.

4 2.1.2 The Exchange Market ( 交易所市场 ) The exchange market for the Chinese bond market is part of the two Stock Exchanges located in Shanghai and Shenzhen, which were established around 1991 in the wake of State-Owned-Enterprise (SOE, 国有企业 ) and financial reform. In August 1995, the exchange-based bond market was designated as the only legitimate bond market in China. This dominant position came to an end on May 1997 when the PBoC, who worried about the overheated Chinese stock market fueled by bond repo financing, ordered all commercial banks to switch to the newly established interbank market on June 1997 (see Section 4.1 for more details). Despite this setback, the exchange market has been keeping its pace with the rapid growth of the ever-complicated Chinese financial system. At the end of 2017, the value of outstanding bonds in the exchange market reached 8.4 trillion RMB, with an annual issuance of 2.2 trillion RMB in The regulator of the exchange bond market is China Security Regulatory Commission (CSRC, 证监会 ), the powerful agency that is overseeing the Chinese stock markets. The participants of the exchange bond market include both institutional players and retail household investors, with only spot and repurchase transactions available. Electronic order books aggregate all bids from investors, and matched trades are settled via China Security Depository & Clearing Co. Ltd (CSDC, 中证登 ). 2.2 Bond Types We classify the fixed-income securities in Chinese bond market into three broad categories based on issuing entities: government bonds, financial bonds, and corporate bonds (that are issued by non-financial sectors). There is also another widely used classification among practitioners in China, which groups financial bonds and corporate bonds together as the so-called Credit Bonds. Note that, in Chinese bond market, the issuers are still dominated by government or entities directly owned by the government (e.g., SOEs, most commercial banks, etc.) Consistent with international practice, overall speaking, the creditworthiness of these bond instruments is decreasing in these three broad categories. Although corporate bonds in some international context also include long-term bonds issued by financial institutions, we specifically separate out bonds issued by financial institutions, given that almost all entities in Chinese financial sector are state-owned. Figure 3 compares the outstanding bonds in China and U.S. from , by these three categories. We observe relatively large fraction of government bonds (US Treasury) in the US bond market, but the weight of financial bonds and corporate bonds are similar.

5 We now turn to details of these bond types. Table 1 gives two snap shots of the outstanding balances of these bonds by types in Chinese bond markets in 2008 and 2017, and Table 2 gives the outstanding balance and issuance amount by bond types in Government Bonds ( 政府债 ) Treasury Bonds ( 国债 ) Treasury bonds are issued by the Ministry of Finance and backed by the fiscal revenue collected by the central government of China, representing the creditworthiness of China as a sovereign. There are mainly two types of Treasury bonds: book-entry treasury bonds that can be traded and transferred in the market, and certificate treasury bonds which cannot be traded and hence mainly used as a savings vehicle. As one of the key instruments by the PBoC in implementing its monetary policy through open market operations, treasury bonds are one of the most important financial products in today s Chinese financial market, enjoying relatively large issuance and trading volumes with significant secondary market liquidity. At the end of 2017 the Treasury bonds reached 13 Trillion RMB, which is about 18% of the Chinese bond market. This is rather small relative to the importance of US Treasuries in the US bond market (46%). Nowadays, the interest rate offered by Treasury bonds is determined by market mechanism via competitive bidding of participating financial institutions (mainly commercial banks and security firms). The market-clearing Treasury rate is considered to be the benchmark risk-free rate (though, as mentioned later, subject to some adjustment on preferred tax treatment). We will come back to this issue in Section 4.1. Municipal Bond ( 地方政府债 ) Municipal bonds are issued by local governments in China. The market for municipal bonds almost did not exist until the 2009 four-trillion stimulus plan pushed out by Beijing in the wake of 2007/08 global financial crisis. The outstanding municipal bonds grew steadily but rather slowly in the next five years, only to observe a dramatic burst in its issuance volume in As explained later in Section 4.2, this is the outcome from a sequence of noticeable regulatory tightening from Beijing to reign in the ever-growing local government debt problem in the second half of 2014, especially the tone-setting guideline Article 43. As a result, in 2015 local governments issued 2.8 trillion RMB municipal bonds, of which 2 trillion is used to swap the debt initially raised by Local Government Financing Vehicles (LGFVs, 地方政府融资平台 ).

6 At the end of 2017, the outstanding municipal bonds reached 15 trillion RMB, with a value-weighted average maturity of 6.3 years at issuance. Because municipal bonds are assigned to zero risk weights, almost all of municipal bonds in China are held by commercial banks (more than 98% at the end of 2017). Policy Bank Bonds ( 政策银行债 ) China has three policy banks today: China Development Bank, Export-Import Bank of China, and Agricultural Development Bank of China. They were established in 1994 to take over the government-directed lending functions from state-owned commercial banks, and are responsible for financing economic and trade development and stateinvested projects. Policy bank bonds are issued by these three policy banks who are essentially backed by the central government, and hence considered to be quasi-sovereign bonds and risk-free (e.g., they receive zero risk-weight if held by commercial banks). At the end of 2017, there were 13 trillion RMB policy bank bonds outstanding, which actually exceeds the Treasury bonds outstanding issued by Ministry of Finance. The weighted average of maturity at issuance is 7.9 years and two major institutional holders are national commercial banks and mutual funds. It is important to highlight that more than 60% of policy bank bonds are issued by China Development Bank (CDB, 国家开发银行 ). Thanks to its deepness and sheer size, the CDB bond has gained its superb secondary market liquidity (even better than Treasury bonds in some dimension). In addition, from the perspective of most institutional investors, CDB bonds are with same tax-treatment with other fixed-income securities. As a result, CDB bonds are widely accepted as the risk-free benchmark in practice (as opposed to Treasury bonds). Other Government Bonds Other government bonds include central bank bills and other bonds with government support. They are negligible in recent years Financial Bonds ( 金融债 ) We classify all bonds issued by financial institutions, including commercial banks, insurance companies, and security firms, as financial bonds. Because the financial industry, which is considered to be a command-high industry for economic growth, still remains largely state-owned and often with implicit government guarantee, financial bonds are considered to be better risk-profile than corporate bonds issued by non-financial firms. This better risk profile is reflected in a higher rating distribution received by financial bonds (see Figure 6 in Section 5.2); there is little difference in yield spreads between financial and non-financial bonds once conditional on ratings.

7 Negotiable Certificate of Deposits (NCDs, 同业存单 ) As a money market instrument, a NCD is a certificate of fixed-term deposit issued by depository institutions in the interbank market. Often the time it is also called interbank CDs, or just CDs. The NCD market grew rapidly since its inception in December 2013, thanks to its high credit quality (guaranteed by issuing banks), excellent secondary market liquidity, and reasonable premium over risk-free benchmark offered by government bonds). The NCD rates tracks closely with Shanghai Interbank Offered Rate (Shibor, 上海银行间同业拆放利率 ), with a premium of 90 bps over CDB bonds in There were no NCDs at the end of 2008, as shown in Table 1; but at the end of 2017, the outstanding NCDs reached 8 trillion RMB as shown in Table 2. More than 90% of outstanding NCDs are held by other commercial banks. The typical issuers of NCDs are relatively smaller joint-stock commercial banks and urban credit unions, while the buyers of NCDs are large state-own banks (e.g., the Big-five) who enjoy cheap funding sources either from retail deposits or various central bank facilities. 3 Besides large state-owned commercial banks, money market funds and mutual funds (broadly defined to include asset management plans funded by wealth-management products) are also investing in NCDs for favorable returns. Other Financial Bonds Other than NCDs, investors can also invest in senior and/or subordinate bonds issued by commercial banks (large state-owned banks, joint-stock banks, and urban and rural credit unions), insurance companies, security firms, and other financial institutions. These financial bonds contribute to a relative small part of Chinese bond market (about 6.7% of the market at the end of 2017) Corporate Bonds ( 产业债 ) The category of corporate bonds broadly covers all fixed-income securities issued by non-financial firms in China, including asset-backed securities and other convertible securities. Enterprise Bonds ( 企业债 ) 3 The Big-five banks are Bank of China, Construction Bank of China, Commercial and Industrial Bank of China, and Agricultural Bank of China (these banks are often-called the Big-four) and the Bank of Communications. The issuance of NCDs, especially for rural credit unions, was severely curtailed by the recent Macro-Prudential Assessment (MPA, 宏观审慎评估体系 ) regulatory tightening starting May 2017.

8 Enterprise bonds, which emerged as early as in early 1980 s, are an important financial instrument used by nonfinancial firms in China as an alternative to bank loans. After the establishment of the interbank market in 1997, the interbank market became the only market where enterprise bonds were issued and traded, as back then enterprise bonds are mainly issued by SOEs who are not publicly listed in stock exchanges. In 2005, the exchange market started to compete for businesses, and issuing entities can choose to sell their bonds in both markets. As a result, about 90% of enterprise bonds become dual listed since then, and at the end of 2017, about 1/3 (2/3) of enterprise bonds are issued and traded in the exchange (interbank) market. Wang, Wei, and Zhong (2015) and Chen et al (2018) study dual listed enterprise bonds. For historical reasons, enterprise bonds have been always regulated by National Development and Reform Commission (NDRC, 发改委 ), a powerful government agency that is overseeing SOE reform and relatively remote from PBoC and CSRC. The outstanding value of enterprise bonds has reached 3 trillion RMB at the end of 2017, and their investors are mainly commercial banks and mutual funds. One important component of enterprise bonds is Municipal Corporate Bonds (MCB, 城投债 ), 4 which consist of 75.51% of enterprise bonds outstanding at the end of Municipal Corporate Bonds are bonds issued by LGFVs which are state-owned enterprises to support the infrastructure investment, both at the provincial and city level. They are one of the perfect examples of the mixture between planning and market in today s Chinese economy: they are with implicit backing of the corresponding local government (the word Municipal), but in a strict legal sense they are issued by LGFV entities just like other regular corporations (the word Corporate). Exchange-traded Corporate Bonds ( 公司债 ) Exchange-traded corporate bonds stand for corporate bonds that are issued in the exchange market and regulated by CSRC. When first launched in 2007, exchange-traded corporate bonds could only be issued by publicly listed companies. In 2015, the CSRC expanded the eligible list of issuing entities in a significant way, which allowed all firms registered as corporations to issue exchange-traded corporate bonds. Besides, the CSRC also loosened the bond issuance criterion, and gave greenlight to both public issuance as well as private placement. Since then exchange-traded corporate bonds grew rapidly, reaching 5 trillion RMB at the end of Medium-Term Notes ( 中期票据 ) 4 These bonds are also called Urban Investment Construction Bond, or Chengtou Bond which is the phonetic translation of its Chinese name, in other existing papers. Ang, Bai, Zhou (2017) offer the first comprehensive study on the pricing of MCBs, and Liu, Lyu, and Yu (2017) investigate the role of implicit local government guarantees for these bonds.

9 Issued in the interbank market, medium-term notes are mainly used by large SOEs as well as prominent private enterprises since The typical debt maturity at issuance is between three to five years, but also can go as high as ten years. At the end of 2017, the outstanding bond value of medium-term notes reached 4.9 trillion RMB. Commercial Papers (including Super Commercial Paper, 短融及超短融 ) Issued in the interbank market, commercial papers are short-term (generally below one year) financing instruments mainly used by large SOEs as well as prominent private enterprises. For commercial paper, the typical debt maturity at issuance is within 1 year, while for super commercial papers it is about 270 days. Commercial papers were launched in 2005, and at the end of 2017, the outstanding bond value reached 1.5 trillion RMB. Asset-Backed Securities (ABS, 资产支持证券 ) First launched in 2005 and growing by about 52% per year since then, ABS can be issued and traded in both interbank and exchange markets. As a nascent financial product, ABS is the financing engine behind the peer-topeer lending platforms, a burgeoning sector that has been experiencing an astonishing growth recently (for example, the micro-financing arm under Ant Financial Services Group). It is also common for commercial banks to issue ABS backed up by consumer or industrial loans, which essentially removes their on-balance-sheet assets to offbalance-sheet. In 2017, the outstanding value of asset-backed securities reached 1.9 trillion RMB, which was about 10% of the corporate bonds and 2.5% of all bonds. Private Placement Notes (PPN, 定向工具 ) Launched in 2011, PPN represents one of the financial innovations by the interbank market and essentially is a mixture between private debt and public bonds. Non-financial firms can issue PPNs to a relatively small number of select institutional investors, who then may transfer these notes among themselves before their maturity in the interbank market. Relative to other more standard publicly placed bonds, PPNs face much less stringent requirement of information disclosure, as the issuers can even negotiate the particular way of information disclosure with the small number of select investors. This significantly alleviates the concern of information leakage for those smallmedium enterprises, especially for those start-ups in the technology sector. After several years of rapid growth, the outstanding PPN has reached 2 trillion RMB at the end of 2017, which is about 2.7% of the market. Other Corporate Bonds Other bond products include International Institution Bonds ( 国际机构债 ) and Railway Bonds. They are about only 2.4% of the outstanding bond value in 2017.

10 2.3 Summary Table 3 summarizes the comparison between the interbank and exchange markets, with a detailed list of various bond products traded there. Though largely segmented, these two markets overlap in several key bond products, mainly government bonds and enterprise bonds. Starting 2015, the exchange market opened its access to enterprise bonds, which had been issued and traded only in the interbank market before. Chen et al (2018) provides an analysis on the market segmentation of dual-listed enterprise bonds, whose cross-market arbitrage is severely hindered by the transfer-of-depository which is a time-consuming process. 5 The market segmentation is also reflected in the distinct regulators for these two bond markets. The government agency who is overseeing the exchange market is CSRC, the powerful watchdog for Chinese stock market. In contrast, the interbank market is overseen by the central bank PBoC, who is the de-facto gate-keeper of this market. Under the guidance of PBoC, National Association of Financial Market Institutional Investors (NAFMII, 中国银 行间市场交易者协会 ) is a self-regulatory organization established in October 2007 to formulate rules governing institutional participants in the interbank market. Regulatory competition among different government agencies is a recurrent theme commonly seen during the development of Chinese financial system. For reference, Table 4 provides a complete list of regulators specialized to each detailed bond product. Finally, the secondary market liquidity for Chinese bond markets is relatively low compared to Chinese stock market. That lack of bond market liquidity is a universal phenomenon that holds in other developed financial markets like in US and Europe, perhaps due to the fact that natural bond investors say insurance companies plan to keep their holdings until maturity. However, given the unique two-market system in Chinse bond markets, it is interesting to compare the market liquidity between the interbank and exchange markets. As mentioned in Chen et al (2018), there are more trading activities in the exchange market, but the trading volume is quite thin. This reflects the fact that retail investors might speculate in the exchange market, while in the interbank market sophisticated financial institutions only trade whenever they need to. In summary, the interbank market is deeper but lacks immediacy, relative to the exchange market. The coexistence of OTC-based interbank market and exchange-based bond market is an important feature that is unique to Chinese bond markets. For historical reasons, these two markets are under different regulators, and have 5 Suppose investors would like to sell their interbank holdings to the exchange market, perhaps for a better exchange price. According to Chen et al (2018), investors need to apply for transfer of depository from the interbank market (the CCDC, 中债登 ) to the exchange (the CSDC, 中证登 ), which takes about three to four working days in The other way around from exchange to interbank will take a slightly longer process (about four to six working days in 2014). The transfer of depository becomes quicker in recent years, but still takes about a few days.

11 been developed in a relatively independent fashion. Though there have been some effort made by NDRC to integrate these two markets which gives rise to the dual-listed enterprise bonds (Chen et. al, 2018), we expect the coexistence of these two bond markets to last for quite a long time in China. 3 A Brief History of Chinese Bond Markets This section offers a brief account on how the bond market in China has been evolved to what it looks like now. The thread that connects all the milestone events in Chinese bond market is the segmented market system described in Section 2.1: the exchange market and the interbank market. 3.1 Physical Bond Counter Market The development of Chinese bond markets in the modern era started from the resumption of the Treasury bond issuance by Ministry of Finance in Besides the government, a few enterprises as well as financial institutions were also conducting debt financing from either their own employees or outside investors. These non-bank-loan debt instruments became legal enterprise bonds after the release of Regulatory Guidelines of Enterprise Bonds by the State Council in The secondary market for bond trading followed, and in 1988, Ministry of Finance carried out a pilot project for Treasury bond circulation and transfer in 61 cities. Through this program, individual investors can buy and sell Treasury bonds at the bank counters as well as regional trading centers. Trading was done mostly in the form of physical bonds, hence it was called a physical bond counter market (Sun, 2015). 3.2 The Exchange Market Era Many deficiencies emerged during the early 1990 s for this physical bond counter market. Among them, the most critical one is the lack of uniform bond custody system. Fake Treasury bonds were common, as it was extremely difficult for decentralized custody systems to verify the authenticity of the physical paper bonds. The centralized exchange market, with electronic book-entry Treasury bonds, was considered to the solution to this problem. Established in December 1991, the Shanghai Stock Exchange provided uniform bond custody service across the country, and the government was explicit in supporting the development of this exchange bond market. 7 In August 1995, the government officially announced that stock exchanges, including both Shanghai and Shenzhen Stock Exchanges, were the only legitimate bond market in China. This greatly improved the liquidity and 6 Without market-based mechanism at play, allocations of Treasuries were based on apportionment via administrative channels at that time. 7 These initiatives include the pilot program of convertible bonds and the short-lived episode of Treasury futures trading on the exchange. Shanghai Stock Exchange introduced the Treasury future contracts in December 1992, but terminated them in May 1995 after the infamous scandal of The event of 327 Treasury Future Contract. The Treasury future market in the exchange was resumed in September 2013.

12 functioning of the secondary market on these two exchanges, and an exchange-based bond market system has shaped by It was not long before another dramatic turn that pushed the interbank market onto the stage. Keep in mind that the two exchanges in China are developed mainly for equity financing and stock trading. During the first half of 1997, the Chinese stock market experienced an unprecedented boom, witnessing Shanghai A-share index rising from 1000 in early 1997 to above 1500 in May The secondary bond market activities, which involve commercial banks and individual investors, contributed to this speculation-driven stock market surge. Essentially, bond repo transactions in the exchange market allowed investors to use bonds as collaterals to obtain debt financing from banks, which in turn was channeled toward the stock market to fuel its rally. 3.3 The Rise of Interbank Market Worrying about the large amount of bank funds that flowed into the overheated stock market, on June 1997 the PBoC ordered all commercial banks to withdraw from exchanges and switch to the newly established interbank market. The PBoC also mandated that all commercial banks move their Treasury bonds, central bank bills, and financial bonds issued by policy banks into the interbank market under the custody of CCDC. This PBoC-led event marked the beginning of the dramatic growth of interbank bond market. During the next twenty years, the wholesale interbank market, standing in contrast to the more-or-less retail exchange market, has become the dominating pillar of Chinese bond markets. The participants were initially restricted to only 16 head offices of commercial banks in 1997; by the end of 2000, a total of 693 financial institutions, including insurance companies, urban and rural credit cooperatives, and security firms, had become members of the interbank market. In February 2014, facing the rapid rise of shadow banking business, the PBoC allowed 16 large commercial banks to invest their own Wealth Management Products (WMPs, 理财产品 ) in the interbank market. In May 2016, direct accesses to the interbank market were further granted to all qualified institutional investors, including WMPs, investment funds and trust companies. The total number of the interbank market members has reached 6,503 in April 2018, and these financial institutions are covering almost the entire financial system in China nowadays. 3.4 Bond Markets and the Growth of Chinese Economy The rapid and steady development of the Chinese bond market offers great benefit for various economic agents in Chinese economy. First, the interbank market has become the primary place for the Ministry of Finance and government-backed entities like policy banks to issue bonds to finance their activities. Second, it helps the central bank, the PBoC, to implement its open market operations and other monetary policies. For instance, in April 2003

13 the PBoC conducted the first formal open market operation in the interbank market, by issuing central bank bills valued at 5 billion RMB with a maturity of 6 month. We are coming back to this topic in Section 4.1. But perhaps an equally important role played by the Chinese bond market is to channel household savings toward the real sector, which is critical for the Chinese economy to achieve its astonishing growth in the last three decades. Various forms of debt instruments have been developed in both markets. In the interbank market, commercial papers, a form of short-term high-quality enterprise bonds with a typical maturity of below one year, emerged in May 2005; and medium-term notes with a typical maturity of five years saw their debut in April On instruments besides enterprise bonds, the first Asset Backed Securities were issued in the interbank market in December 2005; and the first Municipal bonds (by local governments via Ministry of Finance) in April On the exchange market, listed companies first issued exchange-traded corporate bonds in 2007, and in 2015 CSRC expanded the eligible list of corporate bond issuers to all incorporated companies (as opposed to only listed companies). All these reform activities gave a great boost for the development of corporate bonds market in China. 4 Issues and Recent Trends of Chinese Bond Markets One of the important unique features of the Chinese bond market is the predominance of traditional commercial banks, likely due to the historical/institutional reason. This also explains why the Chinese bond market is deeply intertwined with the shadow banking system in China. We then discuss the recent trend since late 2017 in authorities hardline stance in deleveraging and restraining shadow banking activities, together with opening up Chinese onshore bond markets to international investors. 4.1 Interest Rate Determination and Monetary Policy Transmission The risk-free benchmark interest rates and the associated term structure, which are implied by the prices of all government bonds with various maturities, anchor the pricing of all financial assets in modern financial markets. Like in other modern financial markets, interest rates of newly issued Chinese government bonds are determined via competitive bidding of participating financial institutions (mainly commercial banks and securities firms) in the primary market; they then can trade among each other in the secondary market. Today, it is fair to say that market mechanisms are at work in Chinese bond markets after more than two decades of successful and continuous development. Figure 5 plots the yields for Treasury bonds and CDB bonds for 1 and 10 year maturities, respectively. These four series of interest rates are moving mostly in parallel and varying between 2.5% and 6% since 2012, with slightly lower yields for Treasury bonds (than CDB bonds) due to their tax advantage. Overall, in the past half decade, the

14 term structure of interest rates in China is upward-sloping, and the steadily falling interest rates over the period of made this episode the bull market for Chinese bond traders. Despite the rapid growth in the size of the bond market, it is well-recognized among policy makers and practitioners that Chinese bond markets are still underdeveloped in many key dimensions. Compared to the deep and liquid market for U.S. Treasuries, the market for Chinese government bonds still lacks sufficient liquidity, and is often blamed for its poor functioning in efficient price discovery. The latter role of price discovery is key to the effective monetary policy conducted by the PBoC in stabilizing the Chinese economy. There are several institutional reasons for the steady but somewhat slow development of the Chinese government bonds market toward a full market mechanism. A well-functioning primary and secondary market for risk-free rate determination is an integral part of interest rate liberalization, which started in the late 1980s and saw its formal completion when the PBoC finally lifted the banks deposit rate cap and rolled out the deposit insurance scheme in Second, the 12th five-year plan in 2011 has made it clear that future monetary policies should put more emphasis on market-driven price-targeted tools (e.g., repos with PBoC, and Standing Lending Facilities). At the same time quantity-targeted tools (e.g., M2 growth or total bank credit) and guidance rates frequently published by PBoC remain until today the most effective measures taken by Chinese monetary authorities. Third, from a market design perspective, an entry barrier exists for the primary market, which limits participation in the auctioning of government bonds to qualified financial institutions. Most of market-makers, who serve the secondary market in the interbank market, are commercial banks with unpleasantly high degree of homogeneity in trading strategies and funding sources. Finally, the above-mentioned segmentation between the interbank and exchange markets, with potential violation of the law of one price, hurts price discovery and liquidity of Chinese government bond market. 4.2 The Role of Banks and Shadow Banking Another distinct feature that seems to be inconsistent with the fast development of Chinese bond market is that the participants remain highly concentrated in one particular type of financial institutions: commercial banks. As explained in Section 3.3, the Chinese interbank bond market has been closely intertwined with the banking system ever since the establishment of the bond market in 1997, when commercial banks were mandated by the PBoC to be the first participants of bond issuance and trading. It is crucial to recognize that the official statistics significantly underestimates the dominance of commercial banks in Chinese bond market. It is well-known among practitioners and regulators that in China, commercial banks participate in the bond market via two channels: the direct on-balance-sheet channel, through which the bank s proprietary trading division buys and sells bonds in the interbank market; and the indirect off-balance-sheet channel, where the bank s asset management division sets up some asset management plans (just like Special Purpose

15 Vehicle in the U.S. market) and invest in both interbank and exchange markets. The dominating share of commercial banks (58%) of the interbank bond market in Figure 2 only counts the first channel. This perspective suggests that in Chinese financial system, corporate bonds, to a significant extent, can be considered another form of disguised bank financing. Facilitated by the growingly sophisticated shadow-banking activities, the transfer of on-balance-sheet loans (inside the traditional banking system) to off-balance-sheet assets outside (say corporate bonds) is commonly observed, especially when banks were facing tightened regulation on the overheated real estate sector and LGFV financing. This is why practitioners often argue that, different from other developed countries, in China the shadow banking is literally just the shadow of commercial banks. Let us take the example of WMPs, which are the biggest component of shadow banking in China and the most important vehicle to connect back to the banking system. Starting 2014, China Banking Wealth Management Registration System releases its annual report on WMPs, which gives an official account on the role played by WMPs in today s Chinese financial system. According to these reports, a majority of WMP is invested in the bond market, with the percentage to be 44% in 2016 and 42% in Chen, He, Liu (2018) argue that the China s the shadow banking problem is connected to the local government debt problem, which is further rooted in the four-trillion stimulus rolled out in They document that three to five years after the 2009 stimulus plan, LGFVs need to refinance their maturing bank loans and/or fund the ongoing infrastructure projects. However, soon after mid-2010, indebted LGFVs were squeezed by tightening credit standards from traditional banks. As a result, these LGFVs then started issuing Municipal Corporate Bonds (MCBs, as explained in Section 3.3) in the interbank market. The majority of these MCBs was bought by WMPs, which was sold and implicitly guaranteed by commercial banks. 8 There is another important channel through which commercial banks facilitate industrial firms to issue bonds in the interbank market and hence are exposed to default risk. In China, commercial banks often engage in guarantee provisions on corporate bonds, though it is hard to estimate the severity of this risk exposure. To illustrate this point, consider the interesting case on the scandal of Cosun bonds ( 侨兴债事件 ), which involves financial innovations, shadow banking, and (some malfunctioning of) the commercial banking system. In December 2016, the Cosun Group, a privately-owned Telecommunication company in Guangdong, defaulted on a 8 Chen, He, Liu (2018) find that about 60% of MCBs are invested by WMPs by the end of This 60% number is likely to represent an underestimation of the extent to which MCBs are relying on WMPs with the ultimate endorsement of banks. Before the 2017 regulation tightening on China s shadow banking activities, it was popular for managers of WMPs to invest in asset management plans (or several layers of asset management plans, like CDO square in the US market before the 2007/08 financial crisis), which then eventually invest in MCBs. The official statistics ignores this indirect exposure of WMPs in MCB (hence introducing a downward bias of our estimate). According to practitioners in this market, the rough estimate of the true exposure is that about 70% of MCBs were invested by WMPs around 2016.

16 series of its privately placement notes issued two years ago. 9 Shocked by the default news, retail investors went to Zheshang Insurance, the insurance company who provided insurance on this credit event. But Zheshang Insurance immediately made a public announcement stating that China Guangfa Bank, one of the earliest-incorporated jointstock commercial banks, had promised some guarantee provision to repay Zheshang Insurance at the bond issuance but reneged on its promise. It turned out the Huizhou Branch of China Guangfa Bank provided the fake bond guarantee; this gaurantee helped Cosun to issue these bonds, only to rollover Cosun s maturing loans extended by the Huizhou Branch itself several years ago. 4.3 Regulatory Tightening Starting 2017 The Chinese government is well aware of these shadow of bank activities that essentially tie the commercial banking sector to the financial products offered in the interbank market. The dramatic regulatory change started in 2017 is expected to reshape the Chinese financial market in a profound way, bringing a sea change in the interbank market. Under this new framework, WMPs will be put under the scrutiny of the PBoC for the first time and into its calculations on prudence, capital adequacy and loan growth guidelines. Another equally important regulatory tightening is on the rules of new asset management plans, first proposed in Nov 2017 and released in April 2018 (though still yet to be finalized). The new rules aim to prohibit implicit guarantee and multi-layer structure, the two important ingredients that had contributed to excessively high leverage in China s shadow banking system in the past decade. Not surprisingly, in response to policy tightening, the Chinese bond market experienced a dramatic downward adjustment in The annual increment of the value of outstanding bonds, adding together the interbank and exchange markets, experienced about a 35% of drop going down from 16 trillion RMB in 2016 to 10 trillion RMB in We will come back to this topic in Section 6.2 together with the recent insurgence of corporate default in Chinese bond market. Looking forward, we believe that Beijing s recent effort in streamlining and tightening regulations in the evercomplicated Chinese financial market is well justified. Though it is inevitable to bring pain to market participants in the short-run, a transparent regulatory environment is tremendously important to build a healthy and sophisticated bond market in a modern financial system where market participants understand fully the consequences of their own decisions, including issuance, underwriting, trading, and investment. 9 These notes were placed in a local-government owned (Guangdong) exchange market) but sold through some peer-to-peer platform to retail investors, with the help of financial innovation. Recall that PPNs are only allowed to be invested by a select group of sophisticated institutional investors. However, it turns out that many retail investors are buying pieces of PPNs issued by Cosun group, thanks to the financial innovation by some peer-to-peer lending platform.

17 4.4 Internalization of Chinese Bond Market Despite the fact that the Chinese bond market has developed to be third largest in the world, the foreign participation is miniscule. At the end of 2017, the total foreign holdings of the Chinese bonds reached 1.9 trillion RMB, or around 2.6% of the bond market capitalization. 10 Historically, to gain access to Chinese bond market, offshore investors were required to go through some quotabased foreign investment programs. One of them is the Qualified Foreign Institutional Investor (QFII, 合格境外机构投资者 ) program, which was launched in 2002 and regulated by State Administration of Foreign Exchange (SAFE, 国家外汇管理局, a powerful arm of PBoC) who monitors the remittance and repatriation of funds across the border. Initially QFIIs could only invest in the exchange bond market; since March 2013 they are allowed to get access to the much bigger interbank market. Another closed related program is the Renminbi Qualified Foreign Institutional Investor (RQFII, 人民币合格境外机构投资者 ) program. This program allows domestic financial institutions to establish RMB denominated funds in Hong Kong, attracting offshore RMB in the hands of oversea investors back to the onshore bond market. At the end of 2017, the total quota combining QFII and RQFII was about 1.2 trillion RMB, though the actual usage was just 0.31 trillion RMB (within which about 10% was invested in bonds while the rest was in equities). 11 As a milestone effort in the effort of internalization of RMB, Beijing launched the PBoC bond direct-access program in Based on a case-by-case approval system, this program attracted offshore institutional investors (e.g., foreign central banks and offshore RMB clearing banks) to the Chinese interbank bond market. In July 2015, the PBoC further eased the regulation by allowing institutions with long-term investment mandates--such as foreign central banks and sovereign wealth funds--to participate in the interbank market without quota limits. More importantly, these qualified institutions can follow a registration system, rather than a pre-approval system, to participate in the interbank market. In February 2016, similar accesses were granted to a much wider range of institutional investors, including commercial lenders, insurance companies, securities firms and asset managers (excluding short-term or speculative investors). One year later in February 2017, the SAFE was giving overseas 10 On the other way around, many Chinese firms have actively sought oversea funding sources by issuing foreign-currency denominated bonds (Huang, Panizza, and Portes, 2018). 11 Unfortunately, we only have data for stock investments in QFII. We hence estimate the total investment of QFII and RQFII using 90% invested in stock and 10% in bond and assuming the same investment structure for RQFII.

18 investors access to its foreign-exchange derivatives market to allow hedging of bond positions, a crucial step in attracting foreign inflows. On an almost independent effort, motivated by the success of Stock Connect started in November 2014, China launched its Bond Connect ( 债券通 ) on July Like Stock Connect, Bond Connect is a mutual market access scheme that allows investors from mainland China and overseas to trade in each other's bond markets, through connection between the related mainland and Hong Kong financial infrastructure institutions. Thanks to Hong Kong being the leading world-class financial center, foreign investors offer a warm welcome to Bond Connect: The rise of foreign ownership of mainland bonds in July and August in 2017 almost doubled the pace of the prior year. No doubt, the sophistication and development of mainland bond markets are crucial for advancing RMB internalization, one of the policy goals that has received top priority for Chinese government. Looking forward, given Beijing s strong intention to push forward the liberalization of the mainland bond market, we expect a more and more relaxed regulatory environment for foreign investors to participate. Like-wise, oversea investors are flocking to China s mainland bond market for its strong value and potentially tremendous opportunity. This process is likely to be expedited by the decision of Bloomberg, which announced that, starting April 2019, it will add over 300 China s government bonds into the Bloomberg Barclay s Global Aggregate Bond index. Of course, this progress might be interrupted by the concerns of capital flight in the wake of potential significant slowdown of Chinese economy. 5 Bond Ratings and Rating Agencies A key characteristic of bonds is their credit risk as reflected in ratings. Rating agencies are vital in any financial market. While rating symbols used in China closely follow global standards, the rating scale differs. China has currently de-facto only three rating categories. This section illustrates and discusses the skewed rating distribution. Reasons for this observation include low default rates, ongoing trend of more upgrades than downgrades, implicit guarantees, regulatory requirements and a fierce competition among the domestic rating agencies, which differ little in their ratings assessments. The previous section introduced three different bond types. As ratings for government bonds are always AAA rated, this section focuses on credit bonds including financial and corporate bonds Non-financial credit bonds and corporate bonds are used as synonyms in this section.